the relationship between inflation levels and financial performance of commercial banks

1. Background of the Study
Historical background
Inflation is generally the persistent increase of price level of goods and services in an economy
over a period of time. When price level rises, each unit of currency buys fewer goods and services.
Consequently, inflation results into a reduction in the purchasing power per unit of money, a loss
of real value in the medium of exchange and unit of account within the economy (Boyd and
Champ, 2004).They further observes that high inflation rates are caused by excessive growth of
money supply in the economy compared to the rate of economic growth, a lower rate of inflation
is thus favored since it reduces severity of economic recessions by enabling the labor market to
adjust more quickly in a down turn.
Commercial banks comprise the largest group of depository institutions in size. They perform
functions similar to those of savings institutions and credit unions, that is, they accept deposits
(liabilities) and make loans (Saunders and Cornett, 2003). Thus financial institutions must be
profitable in order to ensure the stability of the financial system during economic crisis like the
one that started at the end of 2007 and was deteriorated after the collapse of Lehman Brothers in
USA. Many studies have attempted to identify the factors affecting banks’ profitability, since their
knowledge is considered very significant for different groups of people such as the managers, the
investors or even the governments. Banks’ management is interested in knowing the determinants
that designate their performance, in order to adjust their policy over them and increase their
prosperity. On the other hand, investors by knowing such kind of information are able to control,
if the financial institutions operate by taking into consideration these factors and invest to them.
Conceptual back ground
The chief measure of price inflation is the inflation rate, the annualized percentage change in a
general price index (normally the consumer price index) over time, The consumer price index
measures movements in prices of a fixed basket of goods and services purchased by a typical
consumer, The inflation rate is the percentage rate of change of a price index over time. Lending
is the most important services that commercial banks do render their customers, in other word
banks grant advances and loan to individuals, government and business organization (Cheboi,
2012).

2. Commercial banks are the most important savings, mobilization and financial resource allocations
institutions, consequently these roles make them an important phenomenon in economic growth
and development. In performing this role, it must be realized that banks have the potential, scope
and prospects for mobilizing financial resources and allocating them to productive investments.
Therefore, no matter the sources of the generation of income or the economic policies of the
country, commercial banks would be interested in giving out loans and advances to their numerous
customers bearing in mind, the three principles guiding their operations which are, profitability,
liquidity and solvency (Cheboi, 2012).
Taner (2000) study on the effects of inflation uncertainty on credit markets reveals that
unpredictable inflation raises interest rates, decreases loan supply and affect loan demand. This
therefore suggests that an increase in inflation may raise the bank lending rates and lead to low
bank lending volumes. Emon (2012)confirms this assertion and states that lenders are very aware
that inflations erodes the value of their money over the time period of a loan, so they increase the
interest rates to compensate for the loss. The increased interest rates may therefore influence the
borrowing patterns for any commercial bank. This also suggests that there is a positive relationship
between the inflation rates and the lending rates even though the extent to which one affects the
other for different time periods is not certain.
Contextual background
Chodechai (2004) while investigating factors that affect interest rates, degree of lending volume
and collateral setting in the loan decision of banks, under notes that Banks have to be careful with
their pricing decisions as regards to lending as banks cannot charge loan rates that are too low
because the revenue from the interest income will not be enough to 2 cover the cost of deposits,
general expenses and the loss of revenue from some borrowers that do not pay. Moreover, charging
too high loan rates may also create an adverse selection situation and moral hazard problems for
the borrowers. However, commercial banks decisions to lend out loans are influenced by a lot of
factors such as the prevailing interest rate, the volume of deposits, the level of their domestic and
foreign investment, banks liquidity ratio, prestige and public recognition to mention a few.
Interest rate is the amount charged as percentage of principal by a lender to a borrower for the use
of assets based on the risk level that is the compensation for the loss of asset’s use by the lender.
Inflation is a key determinant of commercial banks‟ lending rates globally. According to Santoni

3. (1986), inflation depreciates the value of money such that a percentage increase in inflation results
into a similar percentage fall in value of the country’s currency.
Thulani (2012) study investigated the relationship between inflation and interest rate spread in
Kenya and the extent to which the Fisher effect hypothesis holds. The study utilized annual time
series data for the fifteen year period starting from the year 1997 to the year 2011. The study found
that inflation had a long term relationship with interest rate. The previous studies such as Liu et al.
(2000), Ubide (1997), Leheyda (2005) and Khan et al. (2006) have addressed the determinants of
banking lending rates and performance and use of monetary policy by the central banks to control
money markets. From these previous studies, it is evident that none of the studies investigated the
effects of inflation on profitability of commercial banks in Uganda.
Theoretical background
Broadly, inflation theorists attribute inflation to monetary causes and mal adjustments in economic
system (Chand, 2008). The performance of commercial banks has been a considered issue in the
developing countries. This phenomenon is attributed to the crucial role of the commercial banks
in the economy. Further, the performance of banking is important to depositors, owners, potential
investors and policy makers as banks are the effective executors of monetary policy of the
government (Mian et al.2013). This suggests that the volumes of bank lending may partly depend
on the performance of commercial banks.
According to the quantity theory of money, most exactly stated in Professor Fisher's " equation of
exchange," an increase in money and bank credit beyond the needs of trade at a given price level
tends to raise that price level. Such is the common conception of inflation. The equal and
simultaneous movements of total purchasing power and trade would result in a stable price level.
Total purchasing power has been shown to be the sum of two products, namely, the quantity of
money in circulation multiplied by its efficiency (or velocity of circulation) and the quantity of
bank deposits multiplied by their efficiency. If this total purchasing power remains the same but
the quantity of trade declines, there will be inflation. If the quantity of trade remains the same, then
inflation may be caused by increases in the quantity of money or of bank credit, or in their
efficiencies. There can be gold inflation as well as paper money inflation or bank credit inflation
(Smith, William & Blinder, 2006)

4. Problem statement
Despite financial sector reforms in Uganda since the 1980s and 1990s, commercial banks’
performance has remained poor and inefficient in the overall financial intermediation. Poor
performance of the banks have continued to manifest into high levels of credit risk to private
agents, poor asset quality, limited and or inadequate capitalization, operational inefficiencies, and
higher incidences of non-performing loans and higher levels of liquidity risk and high cost in
overall financial intermediation. Poor performance of commercial banks is also blamed on low
levels of economic growth as reflected in the high interest rate spreads, high inflation rates, high
interest rates, lower deposit rates to capital investment, high volatility in exchange rate, and low
growth in GDP and GDP per-capita
Furthermore, the increased trend toward bank disintermediation in Uganda, the role of banks has
remained central in financing economic activities in general and different segments of the market.
Empirical evidence show that a sound and profitable banking sector is in a better position to
withstand negative shocks and contribute to the stability of the financial system. The hogh inflation
in Uganda has been the significant force behind DFCU and other commercial banks’ poor
performance resulting into interest rate spread, high cost of financial intermediation, credit risk
and inefficient and non-competitive financial systems are features of underdeveloped banking
system. This study attempts to bridge the gap by determining the effects of inflation on profitability
of commercial banks in Uganda focusing DFCU Nateete Branch
Specific objective of the study
To establish the effect of high exchange rate on the profitability of commercial banks in Uganda
To assess the influence of high interest rate on the profitability of commercial banks in Uganda
To ascertain the relationship between consumer price index and the profitability of commercial
banks in Uganda

5. Significance
The commercial banks management, especially the top level management will use the study to
understand how inflation affects the financial performance of the commercial banks and set up
strategies in handling its effects.
They will also understand the causes and effects of inflation and positively manage the
consequences for better performance of the commercial banks.
The government and its agencies will be assisted by this study to understand the ideal level of
inflation that will have maximum stimulation of the best financial performance of commercial
banks that will in turn stimulate economic growth.
The researchers and scholars will use the study to get more information about the relationship
between inflation levels and financial performance of commercial banks in Kenya. This will assist
them in their scholarly works.
1.9 Conceptual framework
INDEPENDENT VARIABLE DEPENDENT VARIABLE
INTERVENING VARIABLE
Inflation
- Exchange rate
- Interest rate
- Consumer price index
Profitability
- Return on assets
- Return on equity
- Return on investment
- Bank of Uganda policies
- Government policies
- Economic policies

6. LITERATURE REVIEW
Lots of studies have attempted to identify the major determinants of banks‟ profitability, which is
affected by internal and external determinants. The measures that are used usually, in the literature,
for bank profitability are the return on assets (ROA) and/or the return on equity (ROE) and
especially the average value of them. With the term internal determinants we define bank specific
determinants of profitability, such as capital adequacy, liquidity, operational efficiency (expenses
management), bank size and other. The external determinants are industry-specific and
macroeconomic variables affecting financial institutions‟ profitability. Such external influences
include GDP growth, interest rates, inflation, ownership and other.
Theoretical review
Theoretical models in the money and growth literature analyze the impact of inflation on growth
focusing on the effects of inflation on the steady state equilibrium of capital per output. There are
three possible results regarding the impact of inflation on output and growth: money is neutral and
supernatural in an optimal control frame work considering real money balances (M/P) in the utility
function. The assumption that money as substitute to capital, established the positive impact of
inflation on growth; this result being known as the Tobin effect. The negative impact of inflation
on growth, also known as the anti-Tobin effect, is associated mainly with cash in advance models
which consider money as complementary to capital (Tobin 1999).An increase in the general level
of prices implies a decrease in the purchasing power of the currency. That is, when the general
level of prices rises, each monetary unit buys fewer goods and services. The effect of inflation is
not distributed evenly in the economy, and as a consequence there are hidden costs to some and
benefits to others from this decrease in the purchasing power of money.
According to Greenspan (2002) one theory of inflation is called monetarism. This theory says that
inflation is always present and that it is a monetary problem. This theory also says that the amount
of money that exists will determine the amount of money that people spend. The idea is that the
price of items will go up only if the supply of the items is lower than the demand for the items.
The price of items will also go down if the demand for the items is higher than the supply of the
items. This theory also says that since the amount of spending is determined by the amount of

7. money in circulation the demand for items can be determined by calculating the amount of money
in existence. Because of this theory, one could assume that if the amount of money in circulation
goes up so does the amount of spending and so does the demand for consumer goods. Using this
theory, the only reason that prices would go up is if the amount of money in circulation goes up.
Inflation
Inflation can have positive and negative effects on an economy. Negative effects of inflation
include loss in stability in the real value of money and other monetary items over time; uncertainty
about future inflation may discourage investment and saving, and high inflation may lead to
shortages of goods if consumers begin hoarding out of concern that prices will increase in the
future. Positive effects include a mitigation of economic recessions, and debt relief by reducing
the real level of debt. The effect of inflation on the Ugandan economy has been experienced by
various sectors in the economy including the banking sector. Huybens and Smith (1999) argue that
an increase in the rate of inflation could have at first negative consequences on financial sector
performance through credit market frictions before affecting economic growth. In fact, market
frictions entail the rationing of credit, which reduce intermediary activity and capital formation.
The reduction of capital investment impacts negatively both on long-term economic growth and
equity market activity. However, Azariadis and Smith (1996) emphasize the importance of
threshold level of inflation in the relationship between inflation and financial sector performance
Bank Profitability
The profitability of bank is typically spoken as a function of interior and exterior determinants.
The interior determinants are called micro or bank specific determinants of profitability because
they are initiated from bank accounts like balance sheet or profit and loss account. While on the
other hand the exterior determinants are the variables which are not in the control of bank’s
management. These variables reflect the legal and economic environment which can influence the
process and performance of an economic body. Moreover the expenses of bank are considered
significant determinant of bank’s profitability which is directly associated to the concept of capable
management. For instance Bourke (1989) and Molyneux and Thornton (1992) discovered an
encouraging affiliation among profitability and better-quality management. Another appealing

8. matter is that whether the bank‟s ownership status is associated with its profitability or not but to
support the assumption that private organization will earn comparatively higher profit, small proof
is founded.
The study of Short (1979) is from one of the few studies contributing cross country proof of direct
negative correlation among public owned organization and the profitability of banks. The final set
of the determinants of banks profitability works with macro-economic control variables. Growth
rate of money supply, inflation rate and long term interest rates are usually used as variables. The
issue of the association among inflation and bank’s profitability has been introduced by Revell
(1979). He noted that the consequence of inflation on the profitability of banks depends upon
whether wages and other operating expenses of banks are increasing faster than the inflation.
Exchange rate and profitability of commercial banks
The effect of exchange rate changes on the profitability of commercial banks in Uganda is stronger
for which are often either imported or exposed to import competition so that their prices have a
high degree of co-movement with the exchange rate (Norman and Richards 2010). These goods
include clothing, footwear, household appliances, furniture, motor vehicles, books and recreational
equipment. The transmission may be fairly direct, for example when consumers buy imported
goods, or it may be indirect, where the prices of domestically produced goods and services are
affected by changes in the cost of imported inputs.
Profitability is the primary goal of all business ventures. Without profitability the business will not
survive in the long run. So measuring current and past profitability and projecting future
profitability is very important. Profitability is measured with income and expenses. Business will
makes higher profits when the exchange rate is low and stable and once the exchange rate is
volatile it becomes very risky to invest hence the low profitability (Allen Mark, 2006).
The exchange rate determines the business performance whereby when the exchange rate is high
the volume of goods that can be bought by the same amount of money will reduce and vice versa
(Rey, Helene, 2001) Large exchange rate movements are of the interest to researchers and
policy makers because they may produce hysteretic effects that is persistent reactions of
firms (such as entry and exit) that may not be reversed even when the exchange rate
returns to its initial level. Moreover, the effects of large exchange rate movements may

9. be comparable to the effects of significant episodes of tariff changes. Although in recent
years exchange rate movements have been much larger than trade policy changes, the effect of
exchange rate movements have not been given the same attention as the impact of changes
in trade policy. Where exchange rates are considered, their implications are most often
analyzed at the country or industry level, not at the firm level.
Fung (2004), an appreciation of the domestic currency gives foreign firms a cost advantage
in both domestic and foreign markets, driving some domestic firms out of business. For the sales
of a surviving firm (to both domestic and foreign markets), the model shows two opposing effects
of an exchange rate appreciation. While the cost disadvantage faced by domestic firms
causes each of them to sell less, the exit of some firms leaves the surviving firms with a
larger market share.
Interest rate and profitability of commercial banks
Interest rates measure the price paid by a borrower or debtor to a lender or creditor for the use of
resources during some time intervals (Fabozzi and Modigliani, 2003). Goedhuys (1982), defined
interest rate as the general level in financial assets and claims of all types whether call loans or
debentures, company shares or government bonds, bank overdraft or bill of exchange.
There are nominal and real interest rates. Nominal interest rate is the rate not corrected for inflation.
Nominal interest rate on loan relates the amount of interest on the loan to the amount of money
lent, while real interest rate is that which incorporates the effect of inflation. It is measured in terms
of purchasing power.
The two rates are connected by a simple relation called Fisher Effect, which says that real interest
rate is measured as nominal interest rate minus expected inflation rate, because an expectation
about future inflations definitely affects market interest rate (Kaufman, 1986). The market interest
rate is the interest rate offered most commonly on deposits in banks, other interest bearing
accounts, as well as loan, it is determined by the supply and demand for credit (Farlex, 2009).
Market interest rate largely depends on the supply and demand for credit, competition in the
loanable market, and other economic factors, such as inflation rate.
Due to the competition among the banks interest rate remains in a comparable range. For tracking
and managing the significant development interest rate is to be addressed a significant economic

10. problem (Boulier, Huang &Taillard, 2001; Laubach, 2009). On the other hand, in the profit and
loss statement interest rate also engage in managing the interest component entirely (Buiter &
Panigirtzoglou, 2003). In addition, the interest rate also summarizes the way of whole business
debt summary, including the receipt of debt, excellence of the debt, expectations of visions
participation proportions and fixed floating mixture of the debt ( Brigo & Mercurio, 2006; Einav,
Jenkins, & Levin, 2008).
When interest rate rises up, businesses have to pay more for borrowing. In other words their cost
of taking loan increases which decreases their profitability and due to decrease in profitability
market price of their share also decline. Moreover, a rise in interest rate also decreases the worth
of corporate bond. The interest rate that a bond pays to its holder is not much attractive due to high
interest rate (Accaglobal.com). For borrowing and saving there are various types of interest rates
that bank offers. To set the rate of interest that influence the lively of financial system, central bank
plays a significant role. The central bank executes that job by controlling the loan rate for
interbank. Because it considerably influences the interest rates for loan and savings that
commercial banks offer. The main source of commercial bank’s income is the interest income by
interest rate which is to some extent below or above.
The decline in the interest rate as a common rule is most excellent for the economic atmosphere
because customers can easily pay for taking loan as they don’t have to pay higher interest rate for
taking the loans. To regulate the economic development, interest rate is used as a device. As
economy developed rapidly it will cause inflation in the economy. In other words prices go up to
higher point which reduce the buying power of people which affect the demand of people for goods
and services because of the shifting accessibility of bank loans. But on the other hand when interest
rates are low the cost of borrowing decline which increase the buying power of public and as result
they tend to make investments and spend in different forms.
Lower interest rate also gives opportunity to businesses to take capital investment loan. By making
huge investment in rising sectors and making significant profit, it also enhances the firm’s
confidence. As result the economy become stable and employment opportunities in the country
increases. Another feature of lower interest rate is that it reduces the risk of other party to failure
to pay. It shows that when interest rates are lower people have more disposable income to pay off
their loans and to make savings decision. When trade rates decline, the demand for those

11. manufacturers that sells their goods and services in international markets increase which enhance
the export’s growth and as result it will increase collective demand and improves the economy.
Moreover, boost the income factor of those in work. And it directs to amplify the level of national
income.
Interest rates are applied in various shapes like there are different interest rates for saving account
and for taking loan. Central bank sets the interest rate to control the interest rate that transforms
the interest rates to control the lively of financial system. But the results of the variation in the
interest rate are not constantly the projected results (ehow).Central bank plays many important
roles in the economy but the major task of it is to regulate the interest rates which affect the
financial system. For instance, this can be completed by regulating the interbank loan rate. The
rates that commercial banks present for saving and lending are influenced by interbank interest
rates and banks as result present their rates which are below or above from the interbank rate in
certain percentage. In this way commercial banks earn their profit (ehow).
To check the effect of changes in interest rate on commercial bank’s profitability in Pakistan,
number of studies has been conducted in the past decades. In this section researchers will describe
the profitability of commercial banks and interest rate with the review of previous literature on this
topic. Interest rate is described the certain amount of cash compensated by someone on the
utilization of funds for a specific time period. Moreover when a debtor compensates to creditor
with the amount of cash for the utilization of creditor’s funds for a specific time period, is called
interest rate. Creditors charge the interest rate as percentage of the sum of funds lent. Similarly,
the institutions like bank for the utilization of money pays interest rate to the depositor. Profitability
of bank is described as income by interest or non-interest and after tax profits which are computed
as a amount of income (both interest & non-interest) after the subtraction of provisions and
operating costs (Albertazzi & Gambacorta, 2006).
In our routine life, interest rate plays an important function. It can considerably influence
purchasing power of people. Therefore, as depositor it is essential to focus on these trends in
interest rate because the common trends in interest rate can have a major influence on savings of
people. The major variation in these trends makes it essential to examine the existing investment
opportunities and potential opportunities. The changes in interest rate have significant impact on
banks. The major part of bank‟s revenue comes from the difference in the interest rate that it

12. charges from and pays to customers. Previously, in the commercial bank‟s operations interest rates
have become slight element. To accomplish the stability in the overall economy by managing
foreign trade rates and by controlling the inflation, the SBP uses interest rate as a tool.
Consumer price index and profitability of commercial banks
Although it may vary around the world, most countries use the CPI (Consumer Price Index),
including Australia, as the main indicator of inflation levels. The CPI measures inflation by
constructing a basket of around 100,000 goods and services that are weighted according to their
importance to the metropolitan household. Whilst the CPI does act as a relatively good indicator
of inflation, it does have its limitations. As this ‘basket’ of goods and services is essentially fixed,
it may over-exaggerate the increase in the price level, as it doesn’t account for the technological
improvements in certain goods and services. For example, whilst smartphones are much more
expensive than what mobile phones used to cost over 10 years ago, their functions go beyond of
just being a form of communication. Smartphones can be a gaming platform, business tool, or even
simply an electronic encyclopaedia, with their ease of access to search engines such as Google.
However, when analysing price changes, Central banks are not limited to simply one measure of
inflation in the economy. Central Banks may also use the Core Inflation measurement, as an
indicator of underlying price trends in the economy. Core inflation aims to take out the ‘one-off’
price shocks to the economy, which may either over-exaggerate or underwhelm price changes.
For example, when Cyclone Yasi hit Queensland in 2011, a lot of banana crops were destroyed,
very noticeably decreasing the supply of banana’s, coinciding with a significant increase in prices
to around $3 a banana. Whilst this price shock may hay have most likely coincided with slight

13. increases in Headline Inflationary figures, there would be no change in Core Inflation, as it
eliminates those ‘one-off’ price shocks that may lead economists and analysts astray. Therefore,
when measuring the levels of inflation in the economy, central banks, economists and analysts
alike utilise several measurements of price changes in the economy, in order to fully understand
the bigger picture.